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Summary
There is a classic quip that goes like this: if you’re running a public corporation, the objective is to maximize reported profits, but if you’re running a private company, the goal is to break even at successively higher levels of revenue (in other words, grow the business and minimize taxes paid). This quip highlights the difference between running a company solely on Generally Accepted Accounting Principles (GAAP) and doing what is best for its long-term success. The two are not necessarily opposites, but sometimes there are better measures than GAAP on which to run a company. This includes both nonfinancial metrics as well as non-GAAP financial metrics. There was a time when companies had little choice but to use accounting results as the main tool of business analysis. Today, however, executives have a substantially richer palette of hard data with which to assess their company’s performance. These sources are collected by major enterprise systems such as enterprise resource planning (ERP), supply chain management and sales force automation.

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As a result of proliferation of enterprise computing systems that cover a variety of business processes (including ERP, customer relationship management and supply chain management), companies collect – and therefore have access to – a wider range of business data than ever before. Yet our research shows that a majority of large and midsize companies underutilize the data they already collect in making business decisions and planning. Of course, standard financial data is important, but relying mainly on this information is likely to produce less-than-optimal results. The idea of the balanced scorecard originated in the experience of an executive who was frustrated by his company’s exclusive use of accounting data to measure performance and make decisions. Rather than relying on analysis of margins and ratios alone, he believed his company needed to consider customer satisfaction metrics such as fulfillment ratios and production quality measures. That company was successful in applying nonfinancial information to performance assessments and planning to produce better results. Today, some two decades later, we find too many companies still rely too heavily on GAAP measures to assess their performance.

GAAP measures may not be the best choices. For instance, rather than using GAAP net income, it’s not uncommon for corporations and financial analysts to focus on earnings before interest, taxes, depreciation and amortization (EBITDA) because it gets past the fallacy of including sunk costs in certain kinds of performance measurement and does not presuppose a capital structure to support the business. (We recognize it is not uncommon for sharpies to use it to misrepresent business results, too.) But the business reason to look past depreciation is that including it can produce bad decisions. In technology-driven, asset-intensive businesses like telecommunications, for example, always including depreciation in performance assessments is a sure way of discouraging investment in new technology which, in turn, can delay or prevent actions that could create new revenue streams, enhance competitiveness and increase the long-term value of the business. Similarly, traditional methods of cost accounting may blind companies to the true earning potential of certain products or customers and keep them from increasing earnings by structuring incentive compensation to align better with profitability.

Assessment
It would be terrific if a single number or just a handful of them could tell you all you need to know to run a company well or even to pick stocks wisely. Deciding what to measure is complicated because it depends on why you are doing the measuring and what you want to know. Ventana Research recommends that the performance of individuals and business units should be measured on how well they achieve the most appropriate metrics – those that best align their efforts with the corporation’s strategy. Companies also should limit the number of metrics used to those that are the most important for achieving its objectives. This information will include both financial and nonfinancial numbers. Our research shows that companies are underutilizing their enterprise systems’ ability to provide useful metrics on which to manage their business.

Moreover, even standard financial metrics must be used carefully. Those not intimately familiar with accounting and financial analysis might assume there is a definite “hardness” to accounting numbers. In reality, GAAP is structured to present results in a specific context. This context may or may not be useful for those running a business. Other available measures may (in fact, when used in conjunction with GAAP probably will) give you a clearer picture of how well business units and people are performing in accordance with your company’s strategy.